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Why Following The Herd Is Making You a Bad Investor

You probably don’t notice it, but analysts are influencing your stock choices, and you might be losing as a result.

One of the arguments in favor of picking individual stocks is that you can find undervalued opportunities, invest in them, and achieve out-performance.

But what if your choices are being influenced by outside factors that have nothing to do with the stock itself?

The influence of analystsStocks are covered by analysts, who write reports based on public filings and offer buy and sell recommendations. Generally speaking, the bigger the company, the greater the coverage, so large cap stocks enjoy much more coverage than small and micro cap stocks.

Does analyst coverage affect your investment choices? Research indicates that it probably does.

Source: Flickr / IntangibleArts.

One way to look at the question is to ask what happens when a company loses analyst coverage. A recent paper published in the academic journal The Accounting Review finds that these stocks tend to experience reduced trading volumes, less institutional investor interest, and a widening of bid-ask spreads.

What they don't find is a drop in the companies' economic performance.

The importance of familiarityIn other words, people lose interest in stocks that aren't getting a lot of attention, and the pricing of these stocks can change as a result -- even if there isn't an investing-based reason for it.

You've probably heard of Bank of America(NYSE:BAC), which is the most talked-about bank stock. Maybe you even own some shares.

But have you heard of Greene County Bancorp (NASDAQ:GCBC)? Probably not.

I like Greene County Bancorp primarily because it's in the business of being a bank: Nearly 80% of its income comes from interest, and its noninterest income comes chiefly from straightforward account service charges and debit card fees.

The bank's balance sheet is understandable, which is another advantage over megabanks like Bank of America, which earns only 45% of income from interest and is far from simple.

Whatever your position on these particular banks, it's important to remember that analysts don't necessarily pay attention to good stocks at the expense of bad ones.

It's not an illusion: Even companies going public are highly aware of this. Highly rated analysts can bring in more underwriting business, and there is evidence to suggest that firms actually underprice their IPOs in order to get more attention from top analysts. It's clear analysts routinely pay attention to big and popular stocks at the expense of small and less popular ones.

Overcoming familiaritySo how do investors take advantage of these things and benefit from mass psychology? There is evidence that unpopular stocks tend to outperform their more popular peers.

In a sample of 1,500 companies, the authors of the book The Psychology of Investing found that surprise "news" -- good or bad -- helped unpopular stocks outperform the market by about 4% per year. Good news generated an enormous 8% outperformance.

Source: Flickr / Tax Credits.

Investing like a FoolOf course, smaller stocks, which are the least likely to be heavily covered, can be more volatile and more difficult to value than larger ones. Less information can lead to less accuracy and more risk.

Aswath Damodaran, a professor at the NYU Stern School of Business, recommends three strategies: First, focus on diversifying across stocks. Second, don't forget to do your due diligence -- research and a clear head will serve you well. And third, be patient by keep a long time horizon.

Remember, the easiest way to fix a psychological quirk is to become familiar with it.

If you're pouring over Bank of America just because you're hearing about it all the time, then maybe next time you'll stop yourself and start investigating some of the other banks that don't get so much attention.

Author

Anna began her career in finance as a college intern at a hedge fund, and she hasn’t been able to escape its siren song ever since. She’s done academic research at Harvard Business School and UCLA, was the COO of a wealth management firm, and now writes about finance, economics, behavior, and business.